Destructive Creation

Called to Account

Finance is the art of passing currency from hand to hand until it finally disappears.

- Robert W Sarnoff

US Firms Forced to Account for Stock Options

Washington - Stock options, a favoured perk in Silicon Valley, must be deducted from US public companies' earnings under a long-awaited accounting
rule. After a two-year consultation period, the Financial Accounting Standards Board, the private-sector body that sets US accounting regulations, issued the rule.

"Recognising the cost of share-based payments in the financial statements improves the relevance, reliability, and comparability of that financial
information and helps users of financial information to understand better the economic transactions affecting an enterprise and supports resource allocation
decisions," board member Michael Crooch said. Public companies other than small businesses must apply the rule for financial periods starting after June
15 next year. Small firms have until the business period starting after December 15 next year. About 750 US public companies were already voluntarily
applying the rule for share-based payments or had announced plans to do so, the board said. Microsoft is among the volunteer firms.

The proposal had prompted a firestorm of criticism from small-business advocates and the high-tech community. Some said the board was
overstepping its authority and seeking to regulate corporate governance, while others said it would simply hurt fledgling companies that use stock-options to
lure talented executives. Industry lobbying efforts against the new measure were frantic but fruitless.

Many tech companies - led by Intel, Cisco and Sun - had contended that options were the best way to compensate and recruit employees at startup firms and were vital to economic
productivity. Opponents of the measure also argued there was no reliable model to calculate the value of options. According to CS First Boston research, earnings at 52
companies in the Standard and Poor's 500 would have dropped by more than 25% last year under the rule. Such companies include Apple, PeopleSoft and Yahoo.

Destructive Creation

It is a banking truism that the worst loans are made at the best of times. This survey has
argued that, in America at least, companies' financing arrangements seem to assume that the good
times will continue to roll. But all good things must come to an end. The American
economy cannot continue to grow forever; indeed, it is starting to slow. Stockmarkets still
appear to think that Mr Greenspan will perform yet another miracle, and keep the economy growing at
just the right pace to keep inflationary pressures at bay without bringing it to a
halt. Perhaps he will. But there is a risk, a big risk, that the excesses of boom times will make a bust more likely.

Although American companies are generally considered champions of shareholder value, there is
ample evidence that they have not been acting in shareholders' long-term interests. Instead,
they have been looking after their own short-term ones by forcing up share prices. For big
companies, this has been a simple matter of buying back their own equity with borrowed
money. That, of course, is precisely what corporate-finance theory has been telling them to
do. Moreover, financial economists are forever griping that companies squander shareholders'
money. So what could be better than to give it back? The strategy also has the virtue of
making companies look more profitable. The biggest attraction of share buy-backs, however, is
that they are likely to increase the value of stock options, which make up most of the remuneration of big-company bosses nowadays.

Stock options are fine for young companies to encourage workers to help the business grow, but
for mature firms they are just a way of bilking shareholders. Whether they notice or not, they
have to pay for the options, either out of shareholders' funds or by having their ownership diluted.

Similar scepticism is in order about mergers, which became ever more fashionable even though
countless academic studies show that most of them destroy shareholder value. But if they do not
achieve their stated aims, mergers do produce a couple of other desirable effects. First, the
practice of pooling allows returns of the acquired company to be calculated from a small asset base,
regardless of the actual cost of the purchase. And second, those precious options can be exercised prematurely.

Bond investors, rather late in the day, have started to realise that they are getting an even
worse deal. They are exposed to most of shareholders' risks but get hardly any of the
benefits. Rapid advances in technology make their position more perilous still. Creative
destruction can be a wonderful thing for a few shareholders, but is bad for debt
holders. Technological change is one reason why investors treat even some investment-grade
bonds as lowly junk. Creditworthiness used to be determined by collateral; now, increasingly,
it is determined by human capital, which is far more volatile.

There are two ways of looking at the reactions to all these events. On a charitable view,
markets have been panicking needlessly, whereas credit-rating agencies, whose information is better
than the markets', are being more sensible. On a less charitable view, though, the
credit-rating agencies have been rather slow to adjust to changes in the real world. That,
some reckon, is why Moody's (though not Standard & Poor's) has become much quicker to downgrade companies' debt.

Crunch Time

The bottom line is that the markets have punished bond issuers far more than have the rating
agencies. At long last, banks have started to do likewise. Many banks have had to ramp
up lending to ever more risky credits so as to increase profits. Over the past couple of
years, banks have gone where bond investors have feared to tread. Their lending has been
growing at a giddy pace. Now they are beginning to discover the limits of that
strategy. Their bad debts are increasing and may get worse, perhaps much worse. Bank
of America, Wachovia and Bank One have all had to admit to big increases in bad loans, even in a
strong economy. Now that the economy is slowing down, bank lending is likely to decelerate dramatically.

With both bond investors and banks keeping their hands in their pockets, companies' cost of
borrowing will rise, perhaps steeply. The reason why bond yields have already risen so far is
that there is more demand for finance than there are willing suppliers of it. That
disproportion is likely to grow. In other words, America's present small credit crunch might develop into a big one.

If lenders are starting to worry so much, why not shareholders? The debt of Amazon.com (a
well-worn example but a good one), with a market capitalisation of $6.3 billion, is rated only a
touch above default. The company could come good; indeed, it is one of the few Internet firms
that might. And there are sound reasons why shareholders would want to buy a company with
bags of growth potential when bondholders do not: they get the upside, not the downside.

But the main reason why shareholders have been slow to realise that there could be trouble ahead
is because nobody really knows how to value shares - except by the obvious means of seeing what
people are willing to pay. Analysts do not have a clue either, although they pretend they
do. And companies are equally ignorant about their cost of equity. If anybody had any
idea of the "true" worth of equities, stockmarket bubbles would never arise. Yet another has just burst.

Quite probably, worse is to come. Companies have had to finance their investments and the
servicing of their debts out of cash flow, which is starting to deteriorate. This is partly
because the economy is slowing, and revenues with it, but also because many companies resorted to
trickery to boost their revenues. Many high-tech companies have lent money to their buyers to
purchase their products. Now some of those borrowers are finding it difficult to pay them back.

So far, stock options have helped the cash flow of many companies because they are treated as
expenses by the tax authorities but not by the accounting ones. However, if share prices drop
and options are not exercised, this boost to cash flow will be lost. That could be a big blow to companies such as Microsoft.

For many of the companies that pay their employees in options, a continued fall in their share
price is likely to feed through into higher pay. If employees do not get their rewards from
the stockmarket, they will demand more compensation up front. Higher expenses and falling
revenues will put a big dent in earnings per share. Stockmarkets tend to get upset about
such things. And if shares drop, companies' large debt burdens will be that much heavier.

Higher costs, along with lower spending on technology, would also presumably hit labour
productivity. Much technology spending, and the availability of finance for it, was based on
the assumption that economic growth would continue at its giddy rate of recent years. If such
spending slows sharply, some, at least, of America's productivity miracle may quite possibly turn
out to have been an illusion. The question then is how long will it take the American economy
to unwind the excesses that it has built up.

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